It turns out that bigger is not always better after all. According to a report from De Nederlandsche Bank (DNB), while economy of scale can make investing cheaper for large institutions such as pension funds, it turns out PE and hedge funds aren’t really giving big players any breaks. DNB report authors Dirk Broeders, Arco van Oord, and David Rijsbergen determined that while large institutions did get better deals than smaller investors in fixed income and equity investments, surprisingly private equity, hedge funds and real estate investments do not become cheaper as the size of the investment scales up.
The new paper is titled “Scale Economies in Pension Fund Investments: A Dissection of Investment Costs Across Asset Classes", and uses the 2013 performance, asset allocation, size and cost data from 225 pension funds based in the Netherlands as the data set.
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Diseconomies of scale
The report noted the study data showed clear “diseconomies of scale” for pension funds allocating more than €400 million ($450 million) to private equity funds. These diseconomies were “primarily driven by performance fees”. In fact, somewhat shockingly, a ten-fold increase in assets under management actually resulted in a 41.49 basis points increase in performance fees paid out.
The authors suggest a possible explanation for this apparent anomaly. “A possible explanation for this finding could be that larger funds are better able to select the best-performing private equity funds and therefore pay significantly higher performance fees." Of course, if the return on the investment is significantly higher, then it is worth paying the higher fees.
Hedge fund fees go up instead of down with larger investments
Hedge funds fees were also paradoxically higher. The report noted that for hedge funds, a ten-fold boost in a pension’s assets led to a 33.36 basis points increase in hedge fund performance fees.
Of note, Broeders, van Oord, and Rijsbergen also point out that the study data also show clear diseconomies of scale in real estate investments. “A tenfold increase in real estate investments raises total investment costs [by] 14.55 basis points,” they noted in the report.
The authors argued that these higher costs were very likely related to expenses connected to a variety of different reporting requirements for listed and unlisted property assets.
The report further noted that overall a ten-fold increase in assets under management resulted in a 7.67 basis point decrease in total investment costs, including performance fees.
Fees shrink as investments scale up for commodities, fixed income and equity investments
Broeders, van Oord, and Rijsbergen highlight that pension funds actually achieved the greatest economies of scale in their commodities investments. That said, the authors found this economy of scale advantage disappeared for fund allocations greater than €300 million.
On the other hand, with funds' mainstream equity and fixed income allocations, the report authors noted that “size appears to be an important driver for economies of scale”. The study data showed that a ten-fold increase in assets led to a 4.76 basis point decrease in fixed income investment costs and a 7.75 basis point decrease in equity investment costs.
See full working paper below.